Understanding Call Options: Basics, Benefits, and Strategies
Call option contracts are a popular financial instrument used by traders to speculate on the price movements of an underlying asset or to hedge their existing positions. In this article, we will explore what call options are, how they work, the processes and reasons for buying and selling call options, the differences between these actions, and the associated risks.
Key Points
Call option contracts allow traders to trade a stock with much less capital requirement than outright buying the shares.
Buying call options (or going long) limits the loss potential on a trade to just the premium paid to own the contract.
Selling call options on stocks that are owned (or covered calls), allows a trader to profit from a neutral to bearish market by collecting the premium a buyer of a call option would pay.
Risks of buying call options include premium loss and time decay.
Risks of selling call options include no limit on loss potential and being obligated to sell shares of a stock they own.
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What are Call Options?
A call option is a financial contract that gives the buyer the right, but not the obligation, to purchase a specific quantity of an underlying asset (such as a stock) at a predetermined price (the strike price) within a specified period. The seller of the call option is obligated to sell the underlying asset at the strike price if the buyer exercises the option.
How Do Call Options Work?
When a trader buys a call option, they pay a premium to the seller for the right to buy the underlying asset at the strike price. If the market price of the asset rises above the strike price before the option expires, the buyer can exercise the option to buy the asset at the lower strike price, potentially selling it at the higher market price for a profit. If the market price does not exceed the strike price, the option expires worthless, and the buyer loses only the premium paid.
For instance:
A trader believes Stock XYZ will move higher from the current price of $300.
They purchase a call option for Stock XYZ at a strike price of $300 with a one week expiry on 6/14. This call option contract costed them $200.
On 6/21, Stock XYZ close at a price of $305. The trader executes the contract and purchases 100 shares at the strike price of $300 and immediately sells them at the current market price of $305. The net profit from this trade is ($305 - $300) x 100 shares - $200 premium = $300.
However, most traders will not exercise the call options as described above. As the price of the underlying stock moves higher, the value of your call option will increase as well. You can then sell your call option contract and your profit will be the difference between the premium you paid and the premium of the call option contract at the time of the sale.
Using the same instance as above:
A trader believes Stock XYZ will move higher from the current price of $300.
They purchase a call option for Stock XYZ at a strike price of $300 with a one week expiry on 6/21. This call option contract costed them $200.
On 6/19, Stock XYZ close at a price of $304. The option contract they are holding is now worth $320 and they choose to sell it. The net profit from this trade is $320 - $200 = $120.
Utilizing call options allows a trader to utilize less capital to achieve more significant returns on trades they take. If they trader above only had $300 to trade and they chose to purchase shares of Stock XYZ instead of a call option contract, they would have only been able to trade one share and receive a net profit of $4 when they sell it on 6/19.
Buying Call Options
How to Buy Call Options:
Select an Underlying Asset: Choose a stock or other asset you believe will increase in value.
Choose an Expiration Date: Determine how long you want the option to be valid.
Pick a Strike Price: Select the price at which you want the right to purchase the asset.
Pay the Premium: Buy the call option by paying the premium to the seller
Reasons to Buy Call Options:
Speculation: Traders buy call options to profit from an anticipated rise in the underlying asset’s price.
Leverage: Call options allow traders to control a larger amount of the asset with a smaller investment.
Limited Risk: The maximum loss is limited to the premium paid, unlike owning the asset outright.
As the price of the stock increases, the value of the options contract you hold will increase with it. There is no limit to how much the option will increase in value. However as the stock price decreases, the value of the option will decrease with it, but only to a maximum of the premium paid to own the option.
Selling Call Options
How to Sell Call Options:
Own the Underlying Asset (Covered Call): Selling a call option when you own the asset.
Naked Call: Selling a call option without owning the asset (can only be done with Options level 4 approval).
Collect the Premium: Sell the call option and receive the premium from the buyer.
Reasons to Sell Call Options:
Generate Income: Sellers earn premiums, providing income from the sale of call options.
Hedge Positions: Selling calls can offset potential losses in other investments.
Speculation: Traders may sell calls if they expect the asset price to remain stable or decline.
The intention behind selling a call option is very different. This trade is typically called a Covered Call strategy and you’re only able to do this if you have 100 shares for every call option contract of the stock you want to perform this strategy on. With this trade, you want the price of the stock to stay below the strike price of the call option you sell. If it does, then your max profit is the premium you collected from selling the call option. However if the price closes above your strike price on the expiration date, then you must sell 100 shares of the stock (per contract sold) at the strike price selected.
Risks of Buying and Selling Call Options
These are the risks associated with buying call options:
Premium Loss: If the asset price does not exceed the strike price, the option expires worthless, and the premium is lost.
Time Decay: The value of the option decreases as the expiration date approaches. So if price is not able to move high enough before expiration, the trader can still lose money due time decay.
These are the risks associated with selling call options:
No Limit on Loss Potential: If the asset price rises significantly, the seller must sell the asset at the strike price, potentially at a substantial loss.
Obligation to Sell: The seller is obligated to sell the asset if the option is exercised.
Simple Examples
Example #1 - Buying a Call Option
Scenario: You believe stock XYZ, currently trading at $100, will rise in value.
Action: You buy a call option with a strike price of $105 and an expiration date one month away, paying a $2 premium.
Outcome: If XYZ rises to $110, you exercise the option, buy at $105, and sell at $110, making a profit of $3 per share ($110 - $105 - $2 premium). If XYZ stays below $105, the option expires worthless, and you lose the $2 premium.
Example #2 - Selling a Call Option
Scenario: You own stock XYZ, currently trading at $100, and believe it will not rise significantly.
Action: You sell a call option with a strike price of $105 and an expiration date one month away, receiving a $2 premium.
Outcome: If XYZ stays below $105, the option expires worthless, and you keep the $2 premium. If XYZ rises above $105, you sell the stock at $105, potentially missing out on higher gains but still earning the premium.
Conclusion
Call option contracts offer traders a versatile tool for speculating on price movements, generating income, and managing risk. Understanding how to buy and sell call options, the differences between these actions, and the associated risks is crucial for making informed trading decisions. While call options can provide significant opportunities, they also carry risks that must be carefully managed.
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Disclaimer: The information provided in this article is for educational purposes only and should not be construed as financial advice. Always conduct your own research and consult with a professional financial advisor before making any investment decisions.
